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Monday, March 31, 2008

This follows up on our earlier work on "monsters" (see here and here) -- semiclassical configurations in general relativity with more entropy than black holes of equal ADM mass (second figure below). In this paper we note that if black hole evaporation is complete (no remnants, no spacetime topology change) and physics is unitary, then monsters cannot be part of the Hilbert space of quantum gravity (see first figure below, which is a Penrose diagram of an evaporating black hole). We also introduce another example of high entropy semiclassical configurations, constructed by gluing together closed FRW universes across Einstein-Rosen bridges (third figure below).

The dimensionality of the Hilbert space describing a monster or glued FRW universes is vastly larger than that of the Hilbert space describing the Hawking radiation from a black hole of equal ADM mass. There cannot be a unitary (one to one) map between the two spaces.

I can't take any credit for the nice figures -- they were created by my PhD student David Reeb :-)

Unitarity and the Hilbert space of quantum gravity

Stephen D.H. Hsu, David Reeb

Abstract: Under the premises that physics is unitary and black hole evaporation is complete (no remnants, no topology change), there must exist a one-to-one correspondence between states on future null and timelike infinity and on any earlier spacelike Cauchy surface (e.g., slices preceding the formation of the hole). We show that these requirements exclude a large set of semiclassical spacetime configurations from the Hilbert space of quantum gravity. In particular, the highest entropy configurations, which account for almost all of the volume of semiclassical phase space, would not have quantum counterparts, i.e. would not correspond to allowed states in a quantum theory of gravity.

Saturday, March 29, 2008

Roger Lowenstein, author of When Genius Failed: the rise and fall of Long Term Capital Management, writes cogently about the credit crisis and government intervention in the Times Magazine.

I'd like to hear a believer in efficient markets try to tell the story of Bear Stearns' demise. One week it was OK for them to be levered 30 to 1, the next week it wasn't? When the stock was at 65 people were comfortable with their exposure to mortgages, but then suddenly they weren't? Come on. When the stock was at 65, what was the implied probability of a total collapse, based on out of the money puts? Zero.

Markets are complex dynamical systems that undergo phase transitions. Even sophisticated institutional investors are mostly just following the herd. Prices can disconnect wildly from real value for long periods of time, until suddenly they jump, often overshooting in the other direction. Huge risks, which in hindsight are obvious, build up in plain view while escaping notice from all but a few Cassandras. Robert Rubin, the Chairman of Citigroup, former co-head of Goldman, former Treasury Secretary, doesn't know what a SIV is until after the crisis has hit. Tens of trillions of dollars in off the books credit default swaps are traded (often recorded on scraps of paper!) before Wall St. CEOs, central bankers and regulators realize the instabilities involved.

More from James Surowiecki in the New Yorker. (I love this month's cover :-)

NYTimes: ...Government interventions always bring disruptions, but when Washington meddles in financial markets, the potential for the sort of distortion that obscures proper incentives is especially large, due to our markets’ complexities. Even Robert Rubin, the Citigroup executive and former Treasury secretary, has admitted he had never heard of a type of contract responsible for major problems at Citi.

Bear is a far smaller company, and, it would seem, far simpler. But consider that as recently as three weeks ago, it was valued at $65 a share. Then, as it became clear that Bear faced the modern equivalent of a bank run, JPMorgan Chase negotiated a merger with the figure of $10 a share in mind. Alas, at the 11th hour, Morgan’s bankers realized they couldn’t get a handle on what Bear owned — or owed — and got cold feet. Under heavy pressure from the Fed and the Treasury, a deal was struck at the price of a subway ride — $2 a share.

It is safe to say that neither Jamie Dimon, Morgan’s chief executive, nor Ben Bernanke, the Fed chairman who pushed for the deal, know what Bear is really worth. For the record, Bear’s book value per share is $84. As Meredith Whitney, who follows Wall Street for Oppenheimer, remarked, “It’s hard to get a linear progression from 84 to 2.”

Capitalism isn’t supposed to work like this, and before the advent of modern finance, it usually didn’t. Market values fluctuate, but — in the absence of fraud — billion-dollar companies do not evaporate. Yet it’s worth noting that Lehman Brothers’ stock also fell by half and then recovered within a 24-hour span. Once, investors could get a read on financial firms’ assets and risks from their balance sheets; those days are history.

Firms now do much of their business off the balance sheet. The swashbuckling Bear Stearns was a party to $2.5 trillion — no typo — of a derivative instrument known as a credit default swap. Such swaps are off-the-books agreements with third parties to exchange sums of cash according to a motley assortment of other credit indicators. In truth, no outsider could understand what Bear (or Citi, or Lehman) was committed to. The thought that Bear’s counterparties (the firms on the other side of that $2.5 trillion) would call in their chits — and then cancel their trades with Lehman, perhaps with Merrill Lynch and so forth — sent Wall Street into panic mode. Had Bear collapsed, or so asserted a veteran employee, “it would have been the end: pandemonium and global meltdown.”

Perhaps. Or perhaps, after some bad weeks or months, Wall Street would have recovered. What is scary is the degree to which the Fed assimilated the alarmism on the Street: “These guys are so afraid of an economic cycle,” a hedge-fund manager remarked. And without public airing or debate, it stretched the implicit federal safety net under Wall Street.

To question intervention is not to dispute that markets need rules. But for nearly two decades, Washington has trimmed its regulatory sails. The repeal of Glass-Steagall, which once separated banks from securities firms, and the evolution of new instruments that circumvent disclosure rules have loosened the market’s moorings. Huge pools of capital have been permitted to operate virtually unregulated. Mortgages have been written to the flimsiest of credits. Swelling derivative books have made a mockery of disclosure.

The relaxation of oversight has implied an unholy bargain: let markets operate unfettered in good times, confident that the feds will come to the rescue in bad. In 1998, the Fed intervened to cushion the collapsing hedge fund Long-Term Capital Management; dot-com stocks immediately began their dubious ascent. Then, when the tech meltdown led to a recession and the Fed cut rates to 1 percent, adjustable-rate mortgages became as hot as the iPod. One rescue begets the next excess.

It is true that Bear’s shareholders have suffered steep losses. But the Fed went much further than in previous episodes to calm the waters. Notably, it announced it would accept mortgage securities as collateral for loans — enlarging its role as lender of last resort. (Wall Street jesters had it that the Fed would also be accepting “cereal box-tops.”) Then the Fed extended a backstop line of credit to JPMorgan to tide Bear over; finally, it agreed to absorb the ugliest $30 billion of Bear’s assets.

Here is the text of an interesting talk given by Charlie Munger entitled Academic Economics: Strengths and Faults After Considering Interdisciplinary Needs. Among other things, he discusses physics envy, psychology, behavioral economics and efficient markets. Munger, a billionaire, was Warren Buffet's long time investing partner. He studied briefly at Caltech before attending Harvard Law School, and now lives in Pasadena.

“Charlie is truly the broadest thinker I have ever encountered. From business principles to economic principles to the design of student dormitories to the design of a catamaran he has no equal..." –William H. (Bill) Gates III Microsoft Corporation

...Another example of not thinking through the consequences of the consequences is the standard reaction in economics to Ricardo’s law of comparative advantage giving benefit on both sides of trade. Ricardo came up with a wonderful, non-obvious explanation that was so powerful that people were charmed with it, and they still are, because it’s a very useful idea. Everybody in economics understands that comparative advantage is a big deal, when one considers first order advantages in trade from the Ricardo effect. But suppose you’ve got a very talented ethnic group, like the Chinese, and they’re very poor and backward, and you’re an advanced nation, and you create free trade with China, and it goes on for a long time.

Now let’s follow and second and third order consequences: You are more prosperous than you would have been if you hadn’t traded with China in terms of average well-being in the United States, right? Ricardo proved it. But which nation is going to be growing faster in economic terms? It’s obviously China. They’re absorbing all the modern technology of the world through this great facilitator in free trade, and, like the Asian Tigers have proved, they will get ahead fast. Look at Hong Kong. Look at Taiwan. Look at early Japan. So, you start in a place where you’ve got a weak nation of backward peasants, a billion and a quarter of them, and in the end they’re going to be a much bigger, stronger nation than you are, maybe even having more and better atomic bombs. Well, Ricardo did not prove that that’s a wonderful outcome for the former leading nation. He didn’t try to determine second order and higher order effects.

If you try and talk like this to an economics professor, and I’ve done this three times, they shrink in horror and offense because they don’t like this kind of talk. It really gums up this nice discipline of theirs, which is so much simpler when you ignore second and third order consequences.

The best answer I ever got on that subject – in three tries – was from George Schultz. [Schultz was an MIT economics professor before becoming Secretary of the Treasury and Secretary of State.] He said, “Charlie, the way I figure it is if we stop trading with China, the other advanced nations will do it anyway, and we wouldn’t stop the ascent of China compared to us, and we’d lose the Ricardo- diagnosed advantages of trade.” Which is obviously correct. And I said, “Well George, you’ve just invented a new form of the tragedy of the commons. You’re locked in this system and you can’t fix it. You’re going to go to a tragic hell in a handbasket, if going to hell involves being once the great leader of the world and finally going to the shallows in terms of leadership.” And he said, “Charlie, I do not want to think about this.” I think he’s wise. He’s even older than I am, and maybe I should learn from him.

I regard the amount of brainpower going into money management as a national scandal.

We have armies of people with advanced degrees in physics and math in various hedge funds and private-equity funds trying to outsmart the market. A lot of you older people in the room can remember when none of these people existed. There used to be very few people in the business, [and they were not] who were not very intelligent. This was a great help to me.

Now we have armies of very talented people working with great diligence to be the best they can be. I think this is good for the people in it because if you know enough about money management to be good at it, you will know a lot about life. That part is good.

But it's been carried to an extreme. I see prospectuses for businesses with 40-50 people with PhDs, and they have back tested systems and formulas and they want to raise $100 billion. [Reference to Jim Simons of Renaissance Technologies.] And they will take a very substantial override for providing this wonderful system. The guy who runs it has a wonderful investment record and his system is a lot of high mathematics and algorithms with data from the past." [...]

"At Samsung, their engineers meet at 11pm. Our meetings of engineers (meaning our smartest citizens) are also at 11pm, but they're working on pricing derivatives. I think it's crazy to have incentives that drive your most intelligent people into a very sophisticated gaming system."

Tuesday, March 25, 2008

With the current troubles on Wall Street, New York City's economy is in for a rough patch. Unfortunately, so are the rest of us -- the financial sector accounts for over 20% of all S&P earnings :-(

How do New Yorkers feel about the recent misfortunes of the masters of their universe?

NYTimes: ... For many of the city’s middle class, especially those in the creative class, who have felt sidelined as the city seemed to become a high-priced playground for Wall Street bankers, the implosion of the brokerage house Bear Stearns raises a tantalizing possibility: participation in an economy they have been largely shut out of.

Few romanticize the nearly bankrupt New York of the 1970s or the recession of the late 1980s. But if the city suffers an economic downturn, as many now predict, there are fantasies of New York returning to a pre-Gilded Age, before the average Manhattan apartment cost $1.4 million, SAT tutors charged $500 an hour and dinner entrees crossed the $40 threshold.

...New York City has always been defined by the yawning gap between its haves and have-nots. But the last 15 years have witnessed the rise of a class of financiers whose salaries and bonuses have reached staggering heights. Over the last five years, the median compensation for a managing director working in investment banking rose from $650,000 to $1.37 million, according to Johnson Associates, a compensation consulting firm.

That is a pittance compared with hedge-fund managers. The highest-paid managers earned at least $240 million a year in 2006, according to the Institutional Investor’s Alpha magazine, nearly double the amount of 2005 (and up from a minimum of $30 million in 2002).

Their pay — and eagerness to spend it — has encouraged the growth of a luxury market in everything from groceries to restaurants to spas to specialty boutiques. Witness the Marc Jacobs-ization of the West Village, the surging average price of a two-bedroom apartment in Harlem to $1.1 million, and the rise of $15 tubs of ice cream in, of all places, the Lower East Side, at Il Laboratorio del Gelato.

In a city where the median household income in 2006 was $46,480, it’s no wonder that many people are bitter.

...Robert H. Frank, an economics professor at Cornell, has written about the phenomenon of Americans who feel impoverished because of the towering wealth of those above them. In New York City, he said, those feelings are compounded by the sense that much of the wealth at the top is derived from financial instruments that merely move money around.

“It’s one thing if people are adding value to society,” Professor Frank said. “But there is skepticism that this is all a shell game and these guys are not adding value, at least to the extent that justifies their salaries.”

34k Wall St. layoffs since last July, and another 20k to come? Read what the locals have to say:

March 25th, 2008 9:22 am

Best and the brightest?! Please! They are the greediest and the selfish. I for one am tickled pink that these bankers are finally coming back to earth a bit. They have ruined the entire East Coast as far as affordability. No one except an investment banker or hedge funder can afford a house in a nice area between NYC and Boston. And you can forget about vacation spots - they’re all ruined by them. The ridiculous monopoly money bonuses these “geniuses” receive every Christmas has made me sick for years so my schadenfreude meter is on high.

...Yesterday, waiting for a lunch meeting, I met an old friend for coffee. We wandered into the recently renovated MOMA in midtown, with its quiet sculpture garden. His employer, like all the big banks, is a major donor, and his ID card gained us immediate entry. Manhattan is like a big amusement or theme park for financiers. Relative to their compensation, all the rides (taxis, restauarants, everything but real estate) are free! See the drivers in big black sedans dropping off perfectly groomed, uniformed children at their $25k/y private schools, where the headmistress greets each child by name.

Sunday, March 23, 2008

The mainstream media is finally starting to catch on to the nature of the current credit crisis. One of the key points is that very few of the top people -- CEOs, central bankers, regulators -- really understood what was going on. Some are even starting to admit it.

See this article in the Sunday Times, and dozens of posts on this blog over the last 3 years... Here's a post from 2004 in which I noted that Fannie Mae CEO Franklin Raines didn't seem to understand derivatives accounting.

NYTimes: ...LIKE Noah building his ark as thunderheads gathered, Bill Gross has spent the last two years anticipating the flood that swamped Bear Stearns about 10 days ago. As manager of the world’s biggest bond fund and custodian of nearly a trillion dollars in assets, Mr. Gross amassed a cash hoard of $50 billion in case trading partners suddenly demanded payment from his firm, Pimco.

And every day for the last three weeks he has convened meetings in a war room in Pimco’s headquarters in Newport Beach, Calif., “to make sure the ark doesn’t have any leaks,” Mr. Gross said. “We come in every day at 3:30 a.m. and leave at 6 p.m. I’m not used to setting my alarm for 2:45 a.m., but these are extraordinary times.”

Even though Mr. Gross, 63, is a market veteran who has lived through the collapse of other banks and brokerage firms, the 1987 stock market crash, and the near meltdown of the Long-Term Capital Management hedge fund a decade ago, he says the current crisis feels different — in both size and significance.

The Federal Reserve not only taken has action unprecedented since the Great Depression — by lending money directly to major investment banks — but also has put taxpayers on the hook for billions of dollars in questionable trades these same bankers made when the good times were rolling.

“Bear Stearns has made it obvious that things have gone too far,” says Mr. Gross, who plans to use some of his cash to bargain-shop. “The investment community has morphed into something beyond banks and something beyond regulation. We call it the shadow banking system.”

It is the private trading of complex instruments that lurk in the financial shadows that worries regulators and Wall Street and that have created stresses in the broader economy. Economic downturns and panics have occurred before, of course. Few, however, have posed such a serious threat to the entire financial system that regulators have responded as if they were confronting a potential epidemic.

As Congress and Republican and Democratic presidential administrations pushed for financial deregulation over the last decade, the biggest banks and brokerage firms created a dizzying array of innovative products that experts now acknowledge are hard to understand and even harder to value.

On Wall Street, of course, what you don’t see can hurt you. In the past decade, there has been an explosion in complex derivative instruments, such as collateralized debt obligations and credit default swaps, which were intended primarily to transfer risk.

These products are virtually hidden from investors, analysts and regulators, even though they have emerged as one of Wall Street’s most outsized profit engines. They don’t trade openly on public exchanges, and financial services firms disclose few details about them.

...TWO months before he resigned as chief executive of Citigroup last year amid nearly $20 billion in write-downs, Charles O. Prince III sat down in Washington with Representative Barney Frank, the chairman of the House Financial Services Committee. Among the topics they discussed were investment vehicles that allowed Citigroup and other banks to keep billions of dollars in potential liabilities off of their balance sheets — and away from the scrutiny of investors and analysts.

“Why aren’t they on your balance sheet?” asked Mr. Frank, Democrat of Massachusetts. The congressman recalled that Mr. Prince said doing so would have put Citigroup at a disadvantage with Wall Street investment banks that were more loosely regulated and were allowed to take far greater risks. (A spokeswoman for Mr. Prince confirmed the conversation.)

It was at that moment, Mr. Frank says, that he first realized just how much freedom Wall Street firms had, and how lightly regulated they were in comparison with commercial banks, which have to answer to an alphabet soup of government agencies like the Federal Reserve and the comptroller of the currency.

...Wall Street firms rushed into the new frontier of lucrative financial products like derivatives. Students with doctorates in physics and other mathematical disciplines were hired directly out of graduate school to design them, and Wall Street firms increasingly made big bets on derivatives linked to mortgages and other products.

...ONE of the fastest-growing and most lucrative businesses on Wall Street in the past decade has been in derivatives — a sector that boomed after the near collapse of Long-Term Capital.

It is a stealth market that relies on trades conducted by phone between Wall Street dealer desks, away from open securities exchanges. How much changes hands or who holds what is ultimately unknown to analysts, investors and regulators.

Credit rating agencies, which banks paid to grade some of the new products, slapped high ratings on many of them, despite having only a loose familiarity with the quality of the assets behind these instruments.

Even the people running Wall Street firms didn’t really understand what they were buying and selling, says Byron Wien, a 40-year veteran of the stock market who is now the chief investment strategist of Pequot Capital, a hedge fund.

“These are ordinary folks who know a spreadsheet, but they are not steeped in the sophistication of these kind of models,” Mr. Wien says. “You put a lot of equations in front of them with little Greek letters on their sides, and they won’t know what they’re looking at.”

Mr. Blinder, the former Fed vice chairman, holds a doctorate in economics from M.I.T. but says he has only a “modest understanding” of complex derivatives. “I know the basic understanding of how they work,” he said, “but if you presented me with one and asked me to put a market value on it, I’d be guessing.”

...Timothy F. Geithner, a career civil servant who took over as president of the New York Fed in 2003, was trying to solve a variety of global crises while at the Treasury Department. As a Fed president, he tried to get a handle on hedge fund activities and the use of leverage on Wall Street, and he zeroed in on the credit derivatives market.

Mr. Geithner brought together leaders of Wall Street firms in a series of meetings in 2005 and 2006 to discuss credit derivatives, and he pushed many of them to clear and settle derivatives trading electronically, hoping to eliminate a large paper backlog that had clogged the system.

Even so, Mr. Geithner had one hand tied behind his back. While the Fed regulated large commercial banks like Citigroup and JPMorgan, it had no oversight on activities of the investment banks, hedge funds and other participants in the burgeoning derivatives market. And the industry and sympathetic politicians in Washington fought attempts to regulate the products, arguing that it would force the lucrative business overseas.

“Tim has been learning on the job, and he has my sympathy,” said Christopher Whalen, a managing partner of Institutional Risk Analytics, a risk management firm in Torrance, Calif. “But I don’t think he’s enough of a real practitioner to go mano-a-mano with these bankers.”

...In the meantime, analysts say, a broader reconsideration of derivatives and the shadow banking system is also in order. “Not all innovation is good,” says Mr. Whalen of Institutional Risk Analytics. “If it is too complicated for most of us to understand in 10 to 15 minutes, then we probably shouldn’t be doing it.”

Saturday, March 22, 2008

Or, at least, get a good education so that you can follow progress in health research, and develop enough self-discipline that you can implement the important recommendations. The entire effect may simply be that those capabilities tend to be correlated with income and social status.

NYTimes: ...Dr. Singh said last week that federal officials had found “widening socioeconomic inequalities in life expectancy” at birth and at every age level.

He and another researcher, Mohammad Siahpush, a professor at the University of Nebraska Medical Center in Omaha, developed an index to measure social and economic conditions in every county, using census data on education, income, poverty, housing and other factors. Counties were then classified into 10 groups of equal population size.

In 1980-82, Dr. Singh said, people in the most affluent group could expect to live 2.8 years longer than people in the most deprived group (75.8 versus 73 years). By 1998-2000, the difference in life expectancy had increased to 4.5 years (79.2 versus 74.7 years), and it continues to grow, he said.

After 20 years, the lowest socioeconomic group lagged further behind the most affluent, Dr. Singh said, noting that “life expectancy was higher for the most affluent in 1980 than for the most deprived group in 2000.”

“If you look at the extremes in 2000,” Dr. Singh said, “men in the most deprived counties had 10 years’ shorter life expectancy than women in the most affluent counties (71.5 years versus 81.3 years).” The difference between poor black men and affluent white women was more than 14 years (66.9 years vs. 81.1 years).

...Robert E. Moffit, director of the Center for Health Policy Studies at the conservative Heritage Foundation, said one reason for the growing disparities might be “a very significant gap in health literacy” — what people know about diet, exercise and healthy lifestyles. Middle-class and upper-income people have greater access to the huge amounts of health information on the Internet, Mr. Moffit said.

Thomas P. Miller, a health economist at the American Enterprise Institute, agreed.

“People with more education tend to have a longer time horizon,” Mr. Miller said. “They are more likely to look at the long-term consequences of their health behavior. They are more assertive in seeking out treatments and more likely to adhere to treatment advice from physicians.”

A recent study by Ellen R. Meara, a health economist at Harvard Medical School, found that in the 1980s and 1990s, “virtually all gains in life expectancy occurred among highly educated groups.”

Morgan Stanley emerging markets guru Jonathan Garner says the days of a U.S.-centric world are fading fast

The debate over whether emerging markets are decoupling from the US continues to rumble on. With the US economy slowing and probably heading into recession, the debate is of particular interest at this time. Here Jonathan Garner, managing director and head of global emerging markets equity strategy with Morgan Stanley, explains why he thinks that emerging markets will weather this slowdown far better than in previous US slowdowns.

What are your main reasons for arguing that decoupling is under way?

The emerging markets are now 30% of the global economy at current exchange rates. They are even larger now than developed Europe and their share of global GDP is steadily rising and will continue to rise, I suspect, for the foreseeable future.

Also emerging markets have demography on their side. The emerging world's working age population will increase by another one billion people between now and 2050. The developed world's working age population will shrink by about 120 million—or about one eighth, whereas emerging markets will rise by about 25% from the current level. This and the adoption of the market economy, urbanisation and other profoundly positive trends will keep emerging markets moving forward.

How rapidly is this process moving?

I would say we are exiting the US-centric world pretty quickly. And if we are right about this, emerging markets will contribute over 60% of global growth this year. Last year they contributed about 48%. China alone is contributing more to global growth than the US now and will do so for the foreseeable future. China contributed about 11% last year and will contribute 12% this year. This process is slowly bringing down the global share of US GDP while the share of emerging markets is steadily rising.

The decoupling argument seems to have plenty of sceptics

Decoupling runs against the consensus view. Some people simply don't buy it and don't understand the profound change that is underway. And most people still have this view of the US as the core and emerging markets as the periphery. If you go back to the 1990s that was true to some extent—the core drove the periphery—but that was when you had small emerging countries like Hong Kong, Singapore and Thailand that were exporting to the US. It's very different when you have got really large population emerging market countries adopting a market economy. When that happens their growth really starts to kick in.

How is it different this time?

Some things are happening that don't usually happen in a US recession. Export growth in emerging market countries is still running at 19.9% year-on-year. Look at the last US recession, which began in Jan 2001: Then Emerging Markets export growth plummeted. The reason for this difference is that the US is gradually becoming less and less important. Since 2001 there has been a huge gain in intra-emerging market trade and a huge decline in the share of exports from the emerging markets to the US. As an end-user market the US now takes less than a fifth of emerging market exports. And the biggest growing element is trade with the emerging markets and after that trade with the EU.

How is this reflected in product categories?

If you look at auto sales for example, in China alone they have grown from two million units in March 2002 to 7.5 million December 2007. Auto sales in the Bric countries (Brazil, Russia, India, China) totalled 14 million units in 2007. That's 88% the size of the US market and they are growing at 20% year-on-year which means that within a year the Bric counties will have larger auto sales than the US. If you go back to the last US recession in 2001-02, the Bric countries had auto sales that were less than one-third the size of the US. If you look at the auto sales to population densities—this trend definitely won't stop here.

Are the any other areas where growth has been strong?

It's also true in areas such as personal computers—not an area where you tend to think about decoupling. Back in 2001 the US was twice the size of the Asian market ex-Japan, while in 1998 it was three times the size. Today it is scarcely larger.

It is happening in even smaller ticket items such as mobile phone handsets. The US and Europe together take less than one-third of global handsets. In the last US recession it was more than a half. The vast majority of handsets these days are sold into the emerging markets.

What about spending on infrastructure development?

Infrastructure is very important. We have tried to estimate infrastructure spend and gross fixed capital formation and then looked at the proportion of that that which goes to infrastructure. We reckon that the 29 emerging markets countries that we have modelled will have about $22 trillion over the next 10 years. So rising from about 2% of global GDP in 2008 to about 3.5% of global GDP in 2017. That's a very major improvement and it's a structural driver of global GDP growth as we expect it to be growing faster than overall GDP growth.

How is this spending going to be financed?

It can be funded because the emerging markets countries have got their house in order economically. They are running surpluses and their public sectors are external creditors not debtors. The big debtor is the US. The public sector even in places like Brazil and Mexico is now a creditor. Its gives them huge scope to engage in infrastructure building and at the governmental level almost every emerging markets country has drastic infrastructure spending plans across a whole range of sectors. These include airports, power stations, power stations, property, and railways. It really is a far bigger and probably far longer investment theme than the housing problems in the US right now. People find it hard to get their mind around it right now because it crosses many countries and involves a lot of different sectors.

So do you think a slowdown in the US is going to have much impact on Asia?

Well it will have some—we are expecting a growth deceleration. It would be foolish to argue there would be no effect. But we think it will be quite limited. Much more so than in previous US recessions. Because emerging market countries are no longer just exporting to the US. They are exporting to the EU and to each other to feed their own end-use consumers.

Monday, March 17, 2008

Bear Stearns evaporated over the weekend. Its market cap plummeted from $20B a year ago to $3.5B on Friday to essentially zero this weekend, when JP Morgan acquired them for less than the real estate value of their building in Manhattan. Due to Fed guarantees made to JP Morgan, US taxpayers are on the hook for $30B of the most illiquid mortgage backed securities on Bear's books. The Fed intervened because had Bear been allowed to melt down there would have been chaos in and systemic risk to the financial markets ("too big and interconnected to fail"). The current crisis is much more serious than either the Long Term Capital collapse of 1998 or even the savings and loan crisis of the 1980s.

How do illiquid securities get priced? Ultimately, it's competition between FEAR and GREED. At the moment FEAR is winning -- there are serious mispricings in corporate and municipal bond markets due to gigantic risk premia and a flight to security. Mortgage securities won't bottom out until GREEDY capital (controlled by investors willing to take a risk today in hopes of future profits) is sufficient. The problem is that price recovery can't take place until market confidence returns and, additionally, the ultimate value of mortgage securities depends on future projections about the bursting housing bubble, default rates, overall macro trends, etc. It could take a long time for markets to clear, with the Fed (taxpayers!) acting as the buyer of last resort in the interim.

WSJ: ..."At the end of the day, what Bear Stearns was looking at was either taking $2 a share or going bust," said one person involved in the negotiations. "Those were the only options."

To help facilitate the deal, the Federal Reserve is taking the extraordinary step of providing as much as $30 billion in financing for Bear Stearns's less-liquid assets, such as mortgage securities that the firm has been unable to sell, in what is believed to be the largest Fed advance on record to a single company. Fed officials wouldn't describe the exact financing terms or assets involved. But if those assets decline in value, the Fed would bear any loss, not J.P. Morgan.

The sale of Bear Stearns and Sunday night's move by the Fed to offer loans to other securities dealers mark the latest historic turns in what has become the most pervasive financial crisis in a generation. The issue is no longer whether it will yield a recession -- that seems almost certain -- but whether the concerted efforts of Wall Street and Washington can head off a recession much deeper and more prolonged than the past two, relatively mild ones.

'Uncharted Waters'

Former Treasury Secretary Robert Rubin last week described the situation as "uncharted waters," a view echoed privately by top government officials. Those officials have been scrambling to come up with new tools because the old ones aren't suited for this 21st-century crisis, in which financial innovation has rendered many institutions not "too big too fail," but "too interconnected to be allowed to fail suddenly."

Bear Stearns's sudden meltdown forced the federal government to come to grips with the potential collapse of a major Wall Street institution for the first time in a decade. In 1998, about a dozen firms, with encouragement from the Federal Reserve Bank of New York, provided a $3.6 billion bailout of Long-Term Capital Management that kept the big hedge fund alive long enough to liquidate its positions. Bear Stearns famously refused to participate in that rescue.

The scale of the financial system's troubles are even bigger this time around. Since last summer, the Fed has lowered its target for the federal-funds rate, charged on low-risk overnight loans between banks, to 3% from 5.25%, and it is expected to cut the rate again this week. Last week, the Fed said it would lend Wall Street as much as $200 billion in exchange for a roughly equivalent amount of mortgage-backed securities.

But those moves have failed to soothe investors and lenders, who are worried about the true value and default risk of many debt securities or are hoarding cash to meet their own needs. As worries grew that failing to find a buyer for the beleaguered investment bank could cause the crisis of confidence gripping Wall Street to worsen across the financial system, federal regulators pushed Bear Stearns's board to sell the firm.

Who can forecast or model the future value of a complicated CDO tranche? Only a quant with a PhD. Are the real decision makers and risk takers on Wall Street in the mood to trust those calculations? Certainly not at the moment. Therefore, I predict, for now, very limited bargain hunting by just a few bold investors, and no end to illiquidity.

From a recent Fortune interview with Paul Krugman; he seems to be saying subprime is oversold and there's money to be made for the steely eyed:

Fortune: ...do you think the sense of crisis is turning into a crisis of confidence more than anything else?

I fluctuate on that. I look at the prices on subprime-backed securities. Even the AAA-rated tranche is selling for barely over 50 cents on the dollar, and the rest is essentially worthless, which amounts to a prediction that you're going to get really very little on this stuff. Even if every subprime borrower walks away from his house and a lot of money is lost in foreclosure, it's hard to get numbers that bad. So there might be some overselling in these markets. But on the other hand, a lot of the financial system looks like it's going to shrivel up and have to be rebuilt. And that's not too good.

The other risk is, of course, a dollar meltdown. As the Fed lowers interest rates and (effectively) prints money to stimulate the economy and prop up banks and securities firms, foreign investors must begin to question the future of the dollar as a store of wealth. The same crisis of confidence that brought down Bear could eventually bring down the US dollar.

Sunday, March 16, 2008

Profiles of three high-end (> $1k per hour) prostitutes in NYC. Yes, the internet is the great technology of disintermediation: no pimp or other representation required! How else can a young woman make ends meet in Manhattan?

...These days, men can pore through Web sites filled with client reviews and user ratings for thousands of prostitutes. Searches can be narrowed by hair color, age, body type or behavior — someone offering “GFE,” or girlfriend experience, for example, will act adoringly.

Theirs is a world of mirrors and fantasies, double lives and fake names; the three women told their stories on the condition that they be presented by the names they use in the sex world, but provided their real identities so details could be verified — and they were.

...Ms. O’Donnell, 25, is a Williamsburg hipster with entrancing blue eyes who carries an NPR tote bag and might offer up a few pleasantries on the Whole Foods checkout line before turning back to her Junot Diaz novel.

She came to New York after college to pursue an acting career, and has been working in the sex industry for six years, first as a stripper and lap dancer, lately as a call girl who books her own appointments. She said she relished the time spent with her clients as much as the easy money.

“I’ve traveled to Europe, I’ve met amazing people and I’ve paid off student loans,” said Ms. O’Donnell, a talkative Texan who speaks four languages and is applying to graduate school to study visual arts. “There is no victim here,” she added, “although I can’t claim to speak for every sex worker out there.”

Ms. O’Donnell said she earned about $2,000 a week from a dozen steadies, mostly corporate executives and high-tech geeks who come back two, three or four times a month for the natural breasts, the russett bangs and the coquettish nerdiness she markets online.

...That was the refrain: not my husband. Not my husband. Although most women interviewed for this article had a friend or a relative or knew someone who ...

“I’ve heard thousands of stories from women who got blindsided by a version of this,” said Leslie Bennetts, author of “The Feminine Mistake,” an analysis of the roles of working women and mothers. Husbands who were gay, had second families, or patronized prostitutes.

...But even as so many women spoke of the Spitzer debacle as if such things happen only to colonists at the far end of the galaxy, a quieter cohort watched Ms. Wall Spitzer and shuddered in recognition. One such woman, who requested anonymity to protect her children’s identity, had been married for over a decade to a Wall Street executive when she learned he had been using an escort service. She was shattered by the betrayal, by this new stranger.

“To go to an escort service, there is misogyny and a lack of respect for women,” she recounted. “Not to mention the diseases he could have brought home.”

She remained in the marriage for another year by reasoning that at least her husband hadn’t fallen in love with another woman. “I thought, ‘Well, he’s just got issues.’ I was so busy trying to understand him.”

He loved her, he said, and wanted the marriage to work. She hesitated to leave because she did not want to be seen as a home wrecker.

But she came to see in him an angry, toxic arrogance. “He believed he could do whatever he wanted and not get caught,” she said. “Once you feed that dark side, the monster grows. “There was a Madonna-whore thing going on,” she continued. “He had the perfect wife, the perfect children, the perfect job. But there was still self-loathing.”

She ended the marriage decisively some years ago, when her children were very young. They do not know this darker version of why the marriage collapsed.

But this week’s events brought a resurgence of her old pain. She has been weeping a lot for Ms. Wall Spitzer and her daughters, for herself and her children, for what was and what was not.

“My daughter came home from school after the Spitzer story broke,” the woman added, “and she said: ‘Mom, can you believe this? I feel so sorry for his daughters.’ And I’m thinking, ‘You should only know.’ ”

An overview of recent books on happiness, in the New York Review of Books.

...Beginning in the 1980s, Lykken and his colleagues surveyed 2,310 pairs of identical and fraternal twins, some reared together, others brought up apart, looking to see how closely mood, affect, temperament, and other traits tracked with shared genes and/or a shared environment.

What they found (from a smaller subset of the original group) was that the "reported well-being of one's identical twin, either now or 10 years earlier, is a far better predictor of one's self-rated happiness than one's own educational achievement, income, or status." This held not only for identical twins raised together but for those brought up apart, while for fraternal twins raised in the same household, the likelihood that one's sense of well-being matched one's twin's was, statistically speaking, not much greater than chance.

David Lykken and Auke TellegenUniversity of MinnesotaPsychological Science Vol.7, No. 3, May 1996

Happiness or subjective wellbeing was measured on a birth-record based sample of several thousand middle-aged twins using the Well Being (WB) scale of the Multidimensional Personality Questionnaire (MPQ). Neither socioeconomic status (SES), educational attainment, family income, marital status, nor an indicant of religious commitment could account for more than about 3% of the variance in WB. From 44% to 53% of the variance in WB, however, is associated with genetic variation. Based on the retest of smaller samples of twins after intervals of 4.5 and 10 years, we estimate that the heritability of the stable component of subjective wellbeing approaches 80%.

New paper! Can the scale of quantum gravity be deduced from simple dimensional analysis using low-energy inputs like Newton's constant (G), Planck's constant (hbar) and the speed of light (c)? This leads to the usual estimate of 10^19 GeV for the Planck scale. But it's also possible that renormalization effects (i.e., significant renormalization group evolution of Newton's constant at short distances) cause the true energy at which quantum gravity becomes strong to differ substantially from the naive estimate of 10^19 GeV. We analyze this possibility in the paper. There is an interesting connection to Dvali's work on solving the hierarchy problem by introducing a large number of new particles with conserved charges. He argues that unitarity of black hole evaporation would then require a drastically reduced Planck scale, and our results agree.

We examine whether renormalization effects can cause Newton's constant to change dramatically with energy, perhaps even reducing the scale of quantum gravity to the TeV region without the introduction of extra dimensions. We examine a model which realizes this possibility, and describe experimental signatures from production of small black holes.

Saturday, March 15, 2008

I recommend Sam Sheridan's book A Fighter's Heart:One Man's Journey Through the World of Fighting to anyone who is interested in the fight game (ultimate fighting, martial arts, boxing).

When I started on Sheridan's path 15 years ago, I thought I'd write about it someday, but I never got past a single short essay I posted on my web page.

Sheridan studies muay thai (kickboxing) in Thailand, boxing at Harvard and later in Oakland (with Andre Ward), MMA in Iowa with the Miletich camp, and jiujitsu in Brazil (with BTT). He also travels to Tokyo with Antonio Rodrigo Nogueria ("minotauro" -- former Pride and current UFC heavyweight champion) for his decisive encounter with Fedor Emelianenko.

Sheridan's insights and writing are good. The only problem is the guy has no ground game, so he writes about grappling -- the real heart of fighting -- like a mere journalist :-)

Thursday, March 13, 2008

Nice work if you can get it! (I mean Brian Grazer's gig, not the "cultural attaché" cum intellectual lackey...)

New Yorker: ...The rumor, according to one (unofficial) e-mail: “Oscar-winning producer Brian Grazer (Da Vinci Code, A Beautiful Mind, American Gangster) is looking for a new cultural attaché.” The e-mail explained:

This person would be responsible for keeping Brian abreast of everything that’s going on in the world; politically, culturally, musically. . . . They’re also responsible for finding an interesting person for Brian to meet with every week . . . an astronaut, a journalist, a philosopher, a buddhist monk. . . . There is LOTS of reading for this position! Grazer may ask you to read any book he’s interested in. You’ll probably get to read about 4 or 5 books a week and you may be required to travel with him on his private plane to Hawaii, New York, Europe—teaching him anything he asks you about along the way. . . . You will also be provided with an assistant. . . . Salary is around $150,000 a year. . . . You will be to Grazer what Karl Rove was to Bush.

...Michael Rosenberg, the president of Imagine, the production company Grazer owns with Ron Howard, said that about a hundred would-be attachés have e-mailed résumés since word of the job got out. One was Ed Cooke, twenty-six, a British writer and education consultant. His résumé: philosophy-and-psych degree from Oxford, three languages, a demonstrated interest in “the philosophy of cricket.” “This seemed like a job that would suit me,” Cooke said. He’d sent in a list of interesting people: the medieval scholar Mary Carruthers; the cricket star Shane Warne; Dmitri Nabokov.

But Cooke didn’t make the final cut. By last week, Grazer’s staff had already narrowed the potential attachés down to four finalists, who would interview with the boss. “I’ve met a lot of good candidates,” Grazer said, reached on his cell phone en route to a meeting with the screenwriter for “Angels and Demons.” He said that he’d been hiring cultural attachés for twenty years, ever since he asked Jonas Salk’s assistant to help him track down interesting people in science. Fifteen or twenty people have held the job since then. (The “attaché” title started out as a joke.) “They have to be really resourceful,” Grazer said. “I like to meet people in dangerous organizations, and my cultural attaché finds out who that person is—who runs the Yakuza, or the Masons, or MI5.” The best attaché so far, Grazer said, has been Brad Grossman, the current one, who is leaving the post, after four years. Grossman is thirty-two; he owned a tutoring business before taking the job, and Grazer said that he is especially good at explaining the things he’s asked to learn about—bacteria or makeup or superdelegates. “I’m looking for a person who has that teacherlike quality,” Grazer said. “Also, it’s good to have a person who is a connector, who is liked by people.”

Grazer has had one bad attaché experience. “A few years ago, I hired this really smarty-pants Harvard guy,” he said. “He was just remarkably lazy. If he didn’t get the Wall Street Journal on his desk, it was like it didn’t exist.” Still, he said, the experience came with a lesson: “Under no condition can you teach curiosity.”

Before Grazer became a successful producer, he was—like most people— his own cultural attaché. Two weeks ago, he found a letter he’d written to the physicist Edward Teller during that period. “It made me remember how much work it was,” Grazer said. “I had to do the begging and grovelling and ass-kissing myself. I had to find the newspapers and magazines. Even then, I put so much thought and effort into trying to meet and learn from the people who mattered to me.”

Have a look at this documentary film (trailer below) about global education and competitiveness. The producer is a US venture capitalist who has spent time abroad in China and India.

WSJ: ...Bob Compton, a Memphis-based venture capitalist, ran into many kids like Jack when he was traveling in China and India. They were two and three years ahead of his two teenage daughters -- not just in math and science, but in almost every other subject, too. That discovery prompted him to make a documentary called "2 Million Minutes," which followed students in the U.S., India and China to show how they spent their four years of high school -- which works out to about two million minutes.

The film's conclusion: Chinese high-school students spend almost twice as much time on schoolwork as their American peers. (Indian kids spend half again as much time as Americans.)

In Beijing, Jack used to average three or four hours of homework a day. In his Peoria high school, he spent less than an hour a day. At IMSA, homework demands around two hours a day, and Jack still has two hours to play basketball. He told me he's learning and happy.

Wednesday, March 12, 2008

Times of India: ...as many as 12% [of] scientists and 38% [of] doctors in the US are Indians, and in NASA, 36% or almost 4 out of 10 scientists are Indians.

If that's not proof enough of Indian scientific and corporate prowess, digest this: 34% employees at Microsoft, 28% at IBM, 17% at Intel and 13% at Xerox are Indians.

Nevertheless, having a professor of Indian or Chinese extraction in our department is not considered as adding to our "diversity" -- presumably because it doesn't help Oregon students prepare for the multicultural "workforce of the 21st century" :-/

Note: A commenter suggests the numbers are a bit high; perhaps the real percentages are about half what the Times of India estimates?

Tuesday, March 11, 2008

Although I admired some of Eliot Spitzer's efforts as DA, I can't believe he was stupid or arrogant enough to think that he, a prominent public figure, could get away with using high priced prostitutes ("escorts"). Apparently some of the girls at Emperors Club (his service of choice) had already recognized him as the NY governor, so it was only a matter of time before the whole thing blew up. (Times profile of the escort named in the FBI complaint in which Spitzer is "client 9"; photo below. $1k per hour? You be the judge :-)

Current press reports about how the investigation was initiated are implausible -- the claim is that the IRS was tipped off by Spitzer's banks about some suspicious money transfers (Spitzer was careful not to use his credit card, though it was common practice for other customers of the club) that ultimately led to the prostitution ring. Sounds fishy -- we're talking about no more than tens of thousands of dollars in the accounts of a very rich individual. Why would the banks not contact Spitzer first about the transfers? Don't tell me the IRS is checking out every unexplained transfer of a few thousand dollars from a public figure's accounts. Spitzer had powerful enemies on Wall Street and among the Republican party. Combine that with his holier than thou public persona and it is no surprise that he was a target for this kind of investigation. I hope the guy resigns immediately and disappears from public life.

(The prices quoted below should be enough to convince you that this kind of prostitution is as close to victimless crime as you can get. Nevertheless, Spitzer has been shown to be a liar, hypocrite and violator of the law, so good riddance. Why does politics these days only attract pathological types?)

The WSJ has a nice piece on how the new rich are affecting the escort business.

...the wealth boom — and the explosion in the number of multi-millionaires — has created entirely new pricing levels for escorts. According to the complaint, the Emperors Club escorts charged between $1,000 and $5,000 an hour, depending on their “rankings.” Clients could also pay between $25,000 and $50,000 for a three-day visit. It may be the world’s oldest profession: but the prices reflect the new realities of wealth.

The escorts were well-versed in the lucrative potential of this new market. In the complaint, a prospective escort in London turns down the job based on price, saying that £500 an hour for starting escorts — close to $1,000 an hour — was chump change, especially since it didn’t incldue dinner.

“This is the kind of money I make very easily on photoshoots,” the woman said.

...According to a survey by Russ Alan Prince, president of Connecticut-based wealth-research firm Prince & Associates, in his book “The Sky’s The Limit,” a sizable percentage of the super wealthy use escorts. He surveyed 661 people who owned private jets. It found that 34% of males and 20% of females had paid for sex.

The most popular reason was “unique experiences” (71%), followed by “higher quality experiences” (57%). Conventional wisdom says that the rich visit escorts to avoid messy break-ups or extra demands for cash. But the study shows otherwise: “No strings attached,” ranked last as a reason.

“With the wealthy,” Mr. Prince says “it’s all about power and control and new experiences.”

Monday, March 10, 2008

Let me get this straight. Because there are a lot of Arab-Americans in Detroit, a routine search by an NSA employee could dredge up some communication or transaction of mine with an entity in Detroit, even if it has no connection to a suspected terrorist? Whatever happened to my privacy rights?

Oh, I forgot, they went away thanks to the never ending "war" on terror, which is, apparently, more of a threat to our way of life than facing down a technologically advanced nuclear adversary with thousands of warheads and delivery systems. I had more legal protections of my privacy during the cold war than I do now. See earlier comments here, here and here.

Posted in 2005: ...You might argue that Al Qaeda is more dangerous than the USSR and eastern bloc, with their hundreds of ICBMs and thousands of nuclear warheads, but you'd be crazy. Let me offer the following analogy. While walking home you are confronted by a man with a loaded shotgun. By staring him down and pointing out that you yourself are armed, you avoid having your head blown off. Continuing on your way home, a small dog bites your ankle. Is the dog really a greater threat, just because it bit you, than the guy with the shotgun? If not, why should we allow Bush to unilaterally claim greater security powers than Reagan or Carter had? (Indeed, contravening the existing FISA law of 1978.)

The fact that the NSA has the capability to, e.g., pull up my past internet searches and email traffic, means that the telcos are turning over gigantic amounts of data on each of us to NSA for storage and indexing. The article below states that they don't generally have access to the content of email messages. However, this does not imply that they don't store the content (the text part of the message is a trivial amount of data, not much larger on average than the header information), just that they need a higher level of (FISA?) approval before looking more deeply at the communications. So, if you ever need to recover some lost email that you sent, you could always check with the NSA as a last resort!

WSJ: ...According to current and former intelligence officials, the spy agency now monitors huge volumes of records of domestic emails and Internet searches as well as bank transfers, credit-card transactions, travel and telephone records. The NSA receives this so-called "transactional" data from other agencies or private companies, and its sophisticated software programs analyze the various transactions for suspicious patterns. Then they spit out leads to be explored by counterterrorism programs across the U.S. government, such as the NSA's own Terrorist Surveillance Program, formed to intercept phone calls and emails between the U.S. and overseas without a judge's approval when a link to al Qaeda is suspected.

The NSA's enterprise involves a cluster of powerful intelligence-gathering programs, all of which sparked civil-liberties complaints when they came to light. They include a Federal Bureau of Investigation program to track telecommunications data once known as Carnivore, now called the Digital Collection System, and a U.S. arrangement with the world's main international banking clearinghouse to track money movements.

The effort also ties into data from an ad-hoc collection of so-called "black programs" whose existence is undisclosed, the current and former officials say. Many of the programs in various agencies began years before the 9/11 attacks but have since been given greater reach. Among them, current and former intelligence officials say, is a longstanding Treasury Department program to collect individual financial data including wire transfers and credit-card transactions.

It isn't clear how many of the different kinds of data are combined and analyzed together in one database by the NSA. An intelligence official said the agency's work links to about a dozen antiterror programs in all.

...the systems then can track all domestic and foreign transactions of people associated with that item -- and then the people who associated with them, and so on, casting a gradually wider net. An intelligence official described more of a rapid-response effect: If a person suspected of terrorist connections is believed to be in a U.S. city -- for instance, Detroit, a community with a high concentration of Muslim Americans -- the government's spy systems may be directed to collect and analyze all electronic communications into and out of the city.

The haul can include records of phone calls, email headers and destinations, data on financial transactions and records of Internet browsing. The system also would collect information about other people, including those in the U.S., who communicated with people in Detroit.

The information doesn't generally include the contents of conversations or emails. But it can give such transactional information as a cellphone's location, whom a person is calling, and what Web sites he or she is visiting. For an email, the data haul can include the identities of the sender and recipient and the subject line, but not the content of the message.

Wednesday, March 05, 2008

If you want to know what it's like to found a technology startup, read Founders at Work: Stories of Startups' Early Days by Jessica Livingston (Web page, Google books, Amazon). She interviews 32 founders of companies such as Apple (Steve Wozniak), Hotmail (Sabeer Bhatia), RIM (Mike Lazaridis) and ViaWeb (Paul Graham). I haven't finished it yet, but so far the stories ring very true.

One complaint I might have is that all these startups succeeded. It would be good to hear from a few founders who crashed and burned! You do get a bit of exposure to failure in this collection, because in almost every story there are close brushes with defeat -- founders running out of cash, having to radically change business models, lay off employees, etc. -- but ultimately there's a happy ending.

I guess I'm an old Silicon Valley hand, because I knew the broad outlines of the stories of almost all the companies in the book, but each interview so far has revealed fascinating details I'd never heard before.

Another nitpick about the interviews, which I think kind of reveals that the author Livingston is not herself an entrepreneur, is that they don't go into very much detail about the financials of the company -- the real nitty gritty of valuations, equity stakes, acquisition prices, how key negotiations (like exits) went. I guarantee you that almost any startup guy (emphasis, perhaps, on "guy"), when hearing the story of another startup, is doing a running calculation in his head of the founders' equity stake and how much they ended up making. It may sound crass but it's absolutely true and I've experienced it many times in conversations ("Hmm, what was the price? What was his stake?").

The best in-depth account of a startup I've read is High Stakes, No Prisoners by Charles Ferguson, who doesn't leave out any of the key details. I read it before I started my first company, and I'm very glad I did. Ferguson is a very interesting character (Times profile); I can't wait to see his new movie on Iraq.

A note to scientists, academics and economists: even if you have no plans to ever start your own company, I recommend this book for the insight it gives into the workings of technological innovation -- Schumpeter's all important process of creative destruction, as wrought by individual entrepreneurs.

Capitalism, Socialism, and Democracy was much more than a prognosis of capitalism's future. It was also a sparkling defense of capitalism on the grounds that capitalism sparked entrepreneurship. Indeed, Schumpeter was among the first to lay out a clear concept of entrepreneurship. He distinguished inventions from the entrepreneur's innovations. Schumpeter pointed out that entrepreneurs innovate, not just by figuring out how to use inventions, but also by introducing new means of production, new products, and new forms of organization. These innovations, he argued, take just as much skill and daring as does the process of invention.

Innovation by the entrepreneur, argued Schumpeter, led to gales of "creative destruction" as innovations caused old inventories, ideas, technologies, skills, and equipment to become obsolete. The question, as Schumpeter saw it, was not "how capitalism administers existing structures,... [but] how it creates and destroys them." This creative destruction, he believed, caused continuous progress and improved standards of living for everyone.

Saturday, March 01, 2008

I think it is safe to say that no one understands quantum mechanics. -- Richard Feynman

Recently I've been lecturing on quantum weirdness (in Einstein's terminology, "spooky action at a distance") in my graduate quantum mechanics class. The main result is Bell's theorem:

No physical theory of local hidden variables can ever reproduce all of the predictions of quantum mechanics.

Usually this result is proved using the Bell inequalities, which have been tested experimentally. The problem with the Bell inequalities is that they are statistical in nature. I prefer to discuss the so-called GHZ states:

| GHZ > = | 000 > - | 111 >

(after Greenberger, Horne and Zeilinger), with which one can demonstrate a much sharper disagreement between local reality and quantum mechanics.

It's interesting that so much time elapsed between Einstein's 1935 paper with Podolsky and Rosen (EPR) that first discussed spooky action at a distance, and Bell's theorem in 1964. Bell was a particle theorist working at CERN who only did foundations of quantum mechanics on the side (he's also the Bell in the Adler-Bell-Jackiw anomaly in quantum field theory). The GHZ paper didn't appear until 1989. For a long time foundations of quantum mechanics was dismissed by physicists as a fringe activity, suitable only for fuzzy headed philosophers. It's only recently, with the explosion of work in quantum information, that there has been renewed interest in the subject.

I find that the hardest thing about teaching this material in class is that, after half a year of training students' brains to think quantum mechanically, it is extremely difficult to get them to feel the weirdness of Bell's theorem and spooky action. It all seems quite normal to them in the context of the course -- they know how to calculate, and that's just how quantum mechanics works!

For my limited thoughts on quantum foundations (mostly about many worlds or "no collapse" formulations), see this talk (PDF) I gave at the Institute for Quantum Information at Caltech, and these blog posts.

Amazingly, I found almost all the reference links above (to GHZ, Bell's theorem, Bell inequality, EPR) on Wikipedia!

Note added: See Dave Bacon on ScienceBlogs for more discussion and some comments. It appears many younger physicists claim to not find QM weird. However, there may be some selection bias towards researchers in quantum information, who generally work in a non-relativistic setting, and may not have thought as much about causality, the light cone, the intricate spacetime structure of quantum field theory, etc. (i.e., unlike Einstein). Or, it could really be a generational change :-)

Nassim Taleb, love him or hate him, has appeared quite a few times on this blog. Personally I find him quite amusing. I like his irreverence for "expert" opinion (especially that of economists) and his skepticism toward finance theory (in particular, towards Black Scholes and assumptions about perfect hedging and normally distributed risks). His earlier book Fooled By Randomness is largely devoted to making the simple point (amazingly, not appreciated by many otherwise very smart people) that it is quite difficult to tell whether success is due to ability or plain luck. In Wall Street terms, when is there enough data to be confident about someone's alpha?

I recently found this interesting essay by Eric Falkenstein, which is quite critical of Taleb and his book The Black Swan. Many of Falkenstein's points are well taken, although one should evaluate his arguments carefully -- his background (worked on VAR, an economics PhD) might predispose him to dislike Taleb. He criticises Taleb's hero Mandelbrot and the use of fractal ideas in finance, but these criticisms point to the fact that the ideas do not lead to easily implementable models, not that they are wrong as a fundamental description of the underlying phenomena. See, e.g., here and here for more discussion. Eventually, he cuts to the chase and notes that Taleb's earlier hedge fund was probably a loser, and that if he had had any success as a trader he wouldn't be out there hawking books and giving lectures on the rubber chicken circuit :-)

Taleb's trading strategy, based on the idea that others in the market are insufficiently aware of fat tailed distributions, was to buy out of the money puts in hopes of a profiting from a catastrophe. Under this strategy his fund constantly lost small amounts of money in hopes of making a big killing. Sadly for Taleb, he never hit the jackpot, although (see the Fooled By Randomness comment above) that doesn't necessarily undermine the validity of the strategy. More damaging, however, is the fact that insurance companies are basically on the other side of Taleb's trade all the time, and they seem capable of generating steady profits for long periods of time. My guess is that any trader who sold a put to Taleb's fund would pad out the price so much that even if their probability distribution were off at the tails, they would still exact a premium over the real value of the option. The deeper out of the money you go, the more careful and suspicious your counterparty is likely to be.

Finally, here's a recent paper by Taleb which is harshly critical of Black-Scholes-Merton.

Falkenstein: ...Taleb argues that the unpredictability of important events implies we should basically forget about all that is predictable, because that’s not where the real money or importance is. So from a risk management perspective, we should ignore Value at Risk, which measures anticipated fluctuations. Further, we should ‘go long’ on these unanticipated events by engaging in quirky activities on the off-chance that we randomly find something, or someone, really valuable.

Success in markets, like life, is a combination of ability, effort, and chance. Much of intelligent thought is distinguishing between what is predictable v. what is unpredictable; it is to any organism's advantage to find out what we can figure out and change, and what is forever mysterious and unalterable (eg, the Serenity Prayer). The brain is constantly predicting the environment, trying to figure out cause and effect so it can better understand the world. Most of what humans process is predictable, but because we take predictable things for granted, they are uninteresting. We can't predict some things, but instead of resorting to nihilism, we merely buy insurance or manage our portfolios--in the broad sense of the term--to have an appropriate robustness. Discovering certain things are basically unpredictable does not diminish our constant focus on trying to predict more and more things. People will disagree on which risks at the margin are predictable, but that's to be expected, and we all hope to be making the right choices that optimize our serenity at the margin of our predictable prowess.

Of course, in the face of being totally wrong in his evaluation of the usefulness of VAR as a tool — it’s ubiquitous in practical management of diverse trading books — Taleb now says he merely warned against naive usage of VAR. However, it was only his absurdly strong statement that VAR was for charlatans that got him mentioned in the Derivatives Strategy article that propelled him into public discourse (conveniently removed from his website, but you can read it online here). Then, as now, he points to anecdotes of imperfection to "prove" his points.

From Taleb's Wikipedia entry circa July 2006, we see where Black Swan thinking goes when applied to an investment strategy: When he was primarily a trader, he developed an investment method which sought to profit from unusual and unpredictable random events, which he called "black swans." His reasoning was that traders lose much more money from a market crash than they gain from even years of steady gains, and so he did not worry if his portfolio lost money steadily, as long as that portfolio positioned him to profit greatly from an extremely large deviation (either a crash or an unexpected jump upwards).

In fact, Mandelbrot also argues for this strategy. Taleb co-authored a paper arguing that most people systematically underestimate volatility. Furthermore, he argues there exists not only a lack of appreciation of fat tails, but a preference for positive skew, in that people prefer assets that jump up, not down, which would imply the superiority of buying out-of-the-money puts as opposed to calls because those negative tails that increase the price of puts are unappreciated.

These assertions present some straightforward tests, which a Popperian like Taleb should embrace. Specifically, buying out-of-the-money options, especially puts (because of negative skew), should, on average, make money. But insurance companies, which basically are selling out-of-the-money options, tend to do as well as any industry (Warren Buffet has always favored insurance companies, especially re-insurers, as equity investments). Studies by Shumway and Coval (2001) and Bondarenko (2003) have documented that selling puts is where all the extranormal profit seems to be. Of all the option strategies, selling, not buying, out-of-the-money puts has been the best performer historically.

Famed New Yorker writer Malcom Gladwell in a 2002 New Yorker article contrasts the thoughtful, pensive Taleb versus the brash cowboy Victor Neiderhoffer: Taleb buys out-of-the-money puts, Neiderhoffer sells them. Taleb is betting on the big blow up, Niederhoffer on the idea that people overpay for insurance. Who was right? Well, Neiderhoffer still ran his flagship fund until September 2007 from a chalet-style mansion in Weston Connecticut . Taleb shut down his Empirica Kurtosis fund at the end of 2004, and the only public data on it suggest a rather anemic Sharpe ratio, below that of the S&P500 (60% in 2000, about zero for the next 4 years, see here), which is consistent with shutting it down, and trying to redescribe it as a hedge or laboratory, and then move into the more profitable business of teaching how to invest. While neither strategy was great, Niederhoffer's was better, if you just look at their lifetimes (management, in this case Taleb, always likes to say that people left positions of power due to desires to be with family or other opportunities, but the bottom line is, selling puts remained immune to family considerations longer than buying puts).

Taleb's big problem is that he misinterprets the mode-mean trade. A mode-mean trade is where a trader finds a strategy with a positive mode, but zero or negative mean. He then uses someone else’s capital to make money off several years of good returns, making good money for creating or managing the strategy, then, when the strategy gives it all back, the investor bears all the loss. That’s a bad strategy for the investor, and the trader who manages it is either naïve or duplicitous. That is, selling extreme options or writing insurance on extreme events at any prices generates a good mode return, but if it underestimates the probability or severity of the bad times, it may generate a zero or negative average return. Buying High Yield debt is a good example. However, just because selling puts is a bad strategy, it doesn't mean buying puts is a good strategy. A Sharpe of 0.2 is a bad long position, but a worse short (because a - 0.2 Sharpe is worse than a 0.2).